BY MICHAEL RANGARIRAI NHETE
THE need for a precise reflection of corporate value in shareholder value has been highly debated in both the academic spheres and business circles.
Many theories with conflicting assumptions have been created with managers adopting value-based management approaches that best suit their respective corporate policies, economic environments and overall strategic plan.
As most businesses enter the reporting season for the year ended December 31, 2020, it is imperative that the dynamics embedded in shareholder value creation versus corporate value are understood to give a robust and comprehensive financial statement analysis.
Corporate value is anchored on configuring a company to be a better business and it manifests in profit maximisation while shareholder value is premised on wealth maximisation.
The primary role of financial managers, through strategic financial management, is to ensure that shareholder value properly reflects corporate value through putting in place strategies that allow investors to generate higher returns in the financial markets.
Success is, therefore, not just measured in terms of traditional accounting models such as earnings per share, but in terms of present value of future cash flows.
Shareholder value creation should be driven from the CEO or CFO through an economic mind-set and not an accounting mind-set.
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More often than not, managers tend to aim for profit maximisation than maximising shareholder value.
There is nothing sinister about it, but concentrating on maximising profits has some adverse effects on business, which make it an inferior objective.
In pursuit for high profits, managers take up risky business ventures which negatively affect the value of the firm.
Management may cut down on critical expenditure such as research and development affecting the long-term operations of the firm.
To understand the link between corporate value and shareholder value, we can examine how a reduction in profitability, a corporate value indicator, increases shareholder value.
There are two ways that managers can deliberately reduce profitability to increase shareholder value.
They can increase expenditure on research and development as well as expansion projects.
This presents growth opportunities that reciprocate to share price increase.
The company can purchase an insurance policy in order to reduce risk.
The premiums reduce profitability, but the share value increases as more investors buy the shares as they feel comfortable from the insurance cushion.
From a risk perspective, in a perfectly competitive market, no shareholder value is created. Investors only receive their risk-adjusted required rates of return dictated by market forces.
Managers can only create or increase shareholder value by crafting some portfolio investment and financial strategies to exploit market imperfections.
Managers can also influence shareholder value by sending the right signals into the market about the company.
One such way is through a dividend pay-out.
The market value of a firm’s shares increases when a company constantly pays out dividends because more investors buy the shares leading to a demand-driven stock price increase.
This is because there is no risk with cash in hand from dividends than unrealised capital gains which might not be realised from returned earnings.
This is commonly known as the bird-in-the-hand theory.
Dividends also show that the firm is healthy and has made sizable cash flows which generate demand for shares and ultimately shareholder value creation.
However, dividend pay-outs may not send a positive signal that leads to shareholder value creation.
If a dividend is not declared and earnings are retained, these are used for business expansion leading to a demand for the firm’s shares by investors as they seek to realise capital gains from the growth prospects.
This raises the share price and shareholder value is created.
Secondly, investors would seek to purchase shares of a firm with low or no dividend pay-outs because of the tax effect.
Earnings growth would presumably lead to stock price increases, and thus lower-taxed capital gains would be substituted for higher-taxed dividends.
Taxes are not paid on gains until a stock is sold.
Therefore, due to time value effects, a dollar of taxes paid in the future has lower effective cost than a dollar paid today.
In any case, if an investor is in dire need for an income, they can synthetically create a dividend by selling off their shares.
Other ways in which managers can create shareholder value include engaging in expansion projects, mergers and acquisitions.
These leads to a demand-driven stock price increase as investors look forward to corporate growth and increase in capital gains as well as increase in future dividends emanating from potential growth in revenue and profitability.
There are various methods that can be employed to carry out the shareholder value creation analysis.
These include Economic Value Added and Market Value Added.
Equipped with this knowledge and understanding, it becomes of great interest to see how ZSE-listed companies managed the shareholder value creation in 2020 in the upcoming financial statements.
While we wait, it could be an interesting preliminary teaser to look at the last financial reports of some of the big and most influential companies listed on the ZSE.
Shareholders in financial services group CBZ Holdings realised a shareholder value creation in the 2019 financial year as shown by a 349,7% advance in the share price despite a 30,3% decline in profits and a decline in Basic EPS from 86,54 cents in 2018 to 60,29 cents in 2019.
Although one may argue that the share price increase is a manifestation of an inflation adjustment, the shareholder value creation can be further linked to the CBZ Holdings share outperforming the ZSE All-Share Index in the last half of the year.
Delta Corporation managed to create shareholder value with the share market price moving from ZWL2,2500 as at March 31, 2019 to ZWL6,3000 as at March 31, 2020.
Subsequently, the firm recorded an inflation-adjusted operating income increase of 19% and EPS increase of 9%.
However, based on objectively assessing the stock price performance by factoring in other economic fundamentals such as inflation, it may not be a true reflection of shareholder value increase or creation.
This could well be just a market-detected price adjustment without a subsequent management influence which is supposed to be driven by exploitation of market imperfections.
- Nhete is a Financial Markets Practitioner. He holds a Master of Science Degree in Finance and Investments, a Bachelors Honours Degree in Banking and Finance, and is studying to become a certified Financial Markets Practitioner with the South Africa Institute of Financial Markets. He can be contacted on 0773 778 826, or [email protected]
